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Success-based fees and milestone payments

When taxpayers incur costs that relate to an acquisition or
restructuring, they generally must capitalize any costs incurred to
facilitate (i.e., investigate or otherwise pursue) the transaction
(Regs. Sec. 1.263(a)-5). When fees paid to service providers are
contingent upon the successful closing of a transaction, taxpayers can
use a facts-and-circumstances test or a safe harbor to determine what
portion of the fees are deemed to “facilitate” that transaction (Rev.
Proc. 2011-29). The IRS Large Business and International (LB&I)
division recently issued a directive telling its examiners, in the
context of investment banking fees, not to challenge taxpayers’
application of the safe harbor to “eligible milestone payments” if the
directive’s requirements are satisfied (LB&I-04-0114-001). The
directive updates and modifies a previous directive from 2013 on the
treatment of milestone payments.

MILESTONE PAYMENTS

Under Regs. Sec. 1.263(a)-5(f) there is a rebuttable presumption that
success-based fees facilitate a transaction and, therefore, must be
capitalized. Because of confusion around what constitutes sufficient
documentation to allow a taxpayer to rebut this presumption, the IRS
established a safe-harbor method of accounting for success-based fees
(Rev. Proc. 2011-29). Under the safe harbor, a taxpayer can elect to
treat 70% of a success-based fee as a nonfacilitative cost and
capitalize the remaining 30%.

Under a 2013 LB&I directive (LB&I-04-0413-002), IRS examiners
were told not to challenge a taxpayer’s treatment of “eligible
milestone payments” when the taxpayer has elected the safe harbor. A
milestone was defined as one of certain specified events (e.g., the
signing of a letter of intent, an exclusivity agreement, or other
similar written communication, or board of directors’ approval of the
transaction) other than a successful closing of the transaction,
provided the event does not occur before a bright-line date defined in
Regs. Sec. 1.263(a)-5(e)(1). (The bright-line date is used to separate
facilitative from nonfacilitative costs.)

UPDATED MILESTONE DEFINITION

Limiting milestones to events that did not occur before the
bright-line date could result in the same type of payment being
treated differently, depending on when it was earned. To fix this
issue, the new directive amends the definition of “milestone” and gets
rid of the limitation. Under the amended definition, “milestone” means
an event, including the passage of time, occurring in the course of a
covered transaction (whether the transaction is ultimately completed
or not). “Milestone payment” means a nonrefundable amount that is
contingent on the achievement of a milestone. “Eligible milestone
payment” means a milestone payment paid for investment banking
services that is creditable against a success-based fee.

For a detailed discussion of the issues in this area, see “IRS
Broadens 70% Safe-Harbor Deduction for Investment Advisory Milestone
Payments,” by David A. Thornton, CPA, and James D. Slivanya, CPA, in
the September 2014 issue of The Tax Adviser.

—Alistair M. Nevius, editor-in-chief, The Tax Adviser

Also look for articles on the following topics in the September 2014
issue of The Tax Adviser: